Inflation Indexation

Use high inflation to bring down your Capital Gain tax

If petrol at Rs 60 a litre and onions a Rs 45 a kg are breaking your back, here's some cold comfort. The high prices could actually help bring down the tax on your long-term capital gains. The taxman understands that inflation is not only burning a hole in your wallet but also destroying the value of your investments over time. So he allows taxpayers to adjust for inflation by opting for indexation in case of long-term capital gains.

Inflation indexation takes into account the rise in consumer prices during the time the investor held an asset and adjusts his buying price accordingly. This lowers the effective profit from the sale of the asset and, therefore, the tax liability.

The key to indexation is the cost inflation index number announced by the government for each financial year. It is used to compute the indexed cost of an asset.

If you sell an asset-property, gold funds and debt-oriented funds --  at a profit, your gains are taxable. If they they are short-term capital gains, they are clubbed with your income for the year and taxed at normal rates. But if the holding period is longer, the gains are treated as long-term capital gains and taxed at a lower rate. The investor has the choice to pay a flat 10% tax on the capital gain or 20% after indexation. 

The taxman has different minimum holding periods for each asset. For debt funds (including fixed maturity plans), debt-oriented hybrid funds (including monthly income plans) and gold exchange-traded funds, this is one year. But for real estate and bullion, the minimum holding period is three years.

Investors in debt funds (especially FMPs) can use the indexation benefit to the hilt. If you had invested in a debt fund at the fag end of a financial year (say, in March 2008) and redeem the investment 13 months later in April 2011, you will be able to avail of indexation benefit of four financial years. In times of high inflation, this can reduce the tax liability to zero.

However, if you exit in February 2011, you will get the indexation benefit of only three years. As the above calculation shows, this may not result in a lower tax liability compared with that in the flat 10% option. so, your debt mutual funds or other assets that are liable for capital gains tax.

High prices could help you lower your tax liability if you opt for cost inflation indexation in case of long-term capital gains. Go through this calculation to find out if you should avail of this option.